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Avoid big losses in your portfolio: Use options strategy to hedge risk

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‘Option’ is a financial instrument that derives its value from the Underlying. The beauty of the instrument lies with its unique payoffs i.e. non-linear and that’s one of the key differentiators when compared to Futures.

‘Option’ is a financial instrument that derives its value from the Underlying. The beauty of the instrument lies with its unique payoffs i.e. non-linear and that’s one of the key differentiators when compared to Futures.

A buyer of an Option has a limited risk to the extent of the premium; however, the reward is open without a cap. On the contrary, an Option Seller (also termed as Option Writer) has a limited profit potential whereas the possible loss is unlimited.

Now we must be guessing why would anyone be willing to ‘Write’ options if the payoff is so un-favourable? Historical data indicates that most of the instruments witnessed oscillation 9 out of 12 months and trends rest of the 3 months.

About 65 percent of the option instruments listed across the globe expires worthless. If we analyze the raw probability, an ‘Option Writer’ has by default a 65 percent probability of winning the premium against the Option Buyer.

Risks:

As the unlimited loss payoff lies in the hands of the Option Writer, they are the one who carries a majority of the risk. For this risk that the writers bear, they need to receive a risk premium which is dependent on the expectation of the underlying movement, its volatility, and the prevailing interest rate.

Buyers on the other side carry a risk of the premium paid up front. Even though it is presumed that option buying is a low risk strategy, one should do the position sizing well as the instrument may have no value on the day of expiry leading to a 100 percent loss.

Pricing:

The question in the back of the mind is who decides the premium? The writer is the one who is selling the instrument and is the risk holder and can have his own pricing model but market works on supply and demand.

The writer who can offer the best quote for the risk and the buyer who can pay maximum for the hedging or directional bet contribute to the order book as the best ask and best bid respectively.

There is no constraint on which model to use as pricing but a general known and widely used is ‘The Black Scholes Merton Model’. Keeping it simple for now, this model helps in calculating the theoretical value of European Options.

It uses Stock prices, Dividends, Strike Price, Interest Rates, Time to Expiry and expected underlying volatility to compute a price.

Understanding the Payoffs:

Buyer’s Example: Mr. A believes NIFTY has potential to close at 10,500 in December 2017 expiry. The 10,200 call option is quoting at 120 and he makes a purchase.

On the day of expiry, if NIFTY closes at 10500, he makes a profit of Rs.180 (Spot – Strike – Premium Paid) which is a whopping 150 percent return on investment.

Whereas if the NIFTY closes below or at 10200 then he loses his entire investment of Rs.120 i.e. a 100 percent loss. A payoff for expiry in between can be calculated by the formula: Spot – Strike – Premium Paid

Author: Subham Agarwal is CEO & Head of Research at Quantsapp Private Limited

Source: https://www.moneycontrol.com/news/trends/expert-columns-2/avoid-big-losses-in-your-portfolio-use-options-strategy-to-hedge-risk-2453267.html

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